Putnam closes a money market fund: how worried should you be?

By Megan McArdle

Putnam is closing down one of its money market funds and distributing the assets:

The Board of Trustees of the Putnam Funds announced today that it has voted to close the institutional Putnam Prime Money Market Fund, effective as of 5:00 p.m. on September 17, 2008, and distribute all fund assets. Putnam Prime Money Market Fund is offered to institutional clients with a minimum initial investment of $10 million. The Trustees' action was not related to the portfolio's credit quality, but was instead a reaction to marketwide liquidity issues. The fund, like Putnam's other money market funds, has no exposure to securities of Lehman Brothers, Washington Mutual or AIG at the parent-company level. The fund's net asset value calculated on September 16, 2008 was $1.00 per share. On September 17, the fund experienced significant redemption pressure. Serious constraints on liquidity in money market instruments created the risk that in order to process redemptions, the fund would realize losses in selling its portfolio securities. In the face of these challenges, the Trustees determined to close the fund to ensure equitable treatment of all fund shareholders.

I've had several people ask me if their money market funds are safe.  This might be a good time for a brief primer on what a money market fund does (though of course, a better time would have been before we all plowed our money into them).

For consumers, money market funds generally function as a cross between a mutual fund and a bank account.  The idea is, you buy shares at a dollar a share.  The plan will invest those shares into low-risk* securities, like commercial paper and treasury notes.  However, unlike a mutual fund, a money market fund strives to keep its per-share Net Asset Value (NAV) at exactly $1 per share.  The idea is that, just like a bank account, every one dollar you put in entitles you to draw exactly one dollar out.  Any interest or appreciation on the fund's assets are distributed as income to the shareholders.  This is the yield that you see quoted on your bank's prospectus--typically higher than a bank account, but not that much higher.

"Breaking the buck" is what happens when a firms assets are no longer adequate to cover that $1 per-share value.  At that point, the fund has to close up and distribute what it has left.

If you have a money market deposit account through your bank, my pet expert assures me that it is insured.  However, if you have a money market fund in your brokerage account, those losses are not covered by the SIPC.  The Securities Investor Protection Corporation (SIPC) has been described as the brokerage equivalent of the FDIC, which insures your bank account up to $100,000 in the event of a collapse.  This is not quite accurate. 

When a bank goes down, if you had $10,585 in a checking account, you're supposed to get $10,585 back with the help of the FDIC.  When a brokerage folds up, it's supposed to return all your securities and cash to you.  Basically, the SIPC makes accounts good if the brokerage runs out of money to pay off its clients.  But it doesn't insure you against losses--all it guarantees
is that you'll get back the assets (cash and securities) that you had in your account.  If AT&T has dropped from $100 to $6, that is not the SIPC's problem.  All they guarantee is that they will give you either $6 or a share of AT&T. 

The SIPC will make investors whole up to $500,000 worth--but only by replacing assets at current market value, not the original asset value.  Nor will they, as far as I can tell, compensate you if your broker's failure leaves you unable to sell a plummeting asset until it is too late.

Thus with a money market fund, the job is to make sure that you get however many shares of the fund you are entitled to.  But if your 10,000 shares are now only worth $3,500, it will not give you back the $6,500 you lost.

If your fund is with a big house like Vanguard or Fidelity, this shouldn't worry you too much; even if they've got a lot of Lehman paper, their pockets are deep enough to write a check to cover the loss.  And they almost certainly will, because allowing investors to lose money on their money market funds would do terrible damage to the company's reputation.  However, if you've got a mutual fund with a smaller house, they might not be able to stump up the money.

That's why spooked investors are rushing to redeem shares in smaller funds, mostly the kind that institutions park their excess cash in (the fund Putnam is closing up had a minimum investment of $10 million).  Most money market funds are only required to disclose their holdings once per quarter--and at that, the information is 60 days old by the time its filed. God knows what kind of toxic waste they've accumulated in the meantime.  I'm told that a number of institutions have been topping up their mutual funds for months rather than let them break the buck and put the firm in line for investor lawsuits.  The fund that failed the other day was apparently one of the unfortunate few that clued in its investors more often.

The problem is not that most of these funds are insolvent--they can't all have bought huge chunks of Lehman paper.  The problem is that they're illiquid.  If a large number of investors all try to sell out at once, they have to dump large blocs of assets at fire sale prices.  That all by itself will make the fund break the buck, even though they were perfectly solvent before everyone asked to have their money back.  Putnam suffered just such a bank run; I expect the institution will be kicking in some cash to make investors whole.

This happened even though Putnam owns no Lehman or AIG paper at all.  Institutions just became fearful of holding money market shares.  I would expect to see more failures/closures over the next few days.

But for most ordinary investors, who bought their funds through a bank or a large brokerage, I would be very surprised if they take a loss on their money market funds.  Especially if you've got the money in a fund that invests only in treasuries, as some do.  Of course, at the interest rates treasuries are paying right now, you might as well take your money out and tuck it under the floorboards.

It's not impossible, of course, and the first people in line in a bank run are the ones who get all their money back.  So you'll have to decide whether you want to risk losing some money, or contributing to an escalating financial crisis.

* Normally

This is dubious as regards Vanguard which is a nonprofit owned by the funds it manages. The only way they could bail out one of their funds would be by assessing the remaining funds and I doubt they would do that.

Though even at its low rates, Vanguard's advisory entity probably has some cash, so it's hard to be sure.

Further update:  Vanguard's public relations department emails to say "
you're correct, Vanguard's mutual structure does not preclude us from maintaining the stability of our money market funds."

Update:  commenter James Shearer, and a friend, point out that technically money market funds don't have to close up when they break the buck.  Practically, however, it's been assumed that they would have to because investors would hasten to get their money out, causing the fund to collapse.  (We don't know, really, because up until now it's been so rare)

Mr Shearer also notes, of my statement that investors in big funds like Fidelity and Vanguard would probably be all right:

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